1. EBIT/EPS Analysis The tax benefit of debt Trade-off theory Practical considerations in the determination of capital structure CAPITAL STRUCTURE Lecture 2

2. Kevin Campbell, University of Stirling, October 2006 2 Capital structure Issues: EBIT-EPS analysis The tax shield benefit of debt The trade-off theory of capital structure Practical considerations that affect the capital structure decision

3. Kevin Campbell, University of Stirling, October 2006 3 Business Risk vs Financial Risk Business risk is the variability of a firm’s Earnings Before Interest and Taxes (EBIT) Financial risk arises from the use of debt, which imposes a fixed cost in the form of interest payments = financial leverage.

4. Kevin Campbell, University of Stirling, October 2006 4 EBIT/EPS analysis Examines how different capital structures affect earnings available to shareholders (EPS) and risk Question: for different levels of EBIT, how does financial leverage affect EPS?

5. Kevin Campbell, University of Stirling, October 2006 5 Risk and the Income Statement Sales Business– Variable costs Risk– Fixed costs EBIT – Interest expense Financial Earnings before taxes Risk– Taxes Net Income EPS =Net Income / no. of shares

6. Kevin Campbell, University of Stirling, October 2006 6 Current and Proposed Capital Structures CURRENT PROPOSED Total assets $100 million $100 million Debt 0 million 50 million Equity 100 million 50 million Share price $25 $25 No. of shares 4,000,000 2,000,000 Interest rate 10% 10% Note: for the purpose of simplicity we ignore taxes in this example

7. Kevin Campbell, University of Stirling, October 2006 7 CURRENT CAPITAL STRUCTURE No Debt, 4 Million Shares (millions omitted) EBIT 50% EBIT 50% BELOW ABOVE BELOW ABOVE EXPECTED EXPECTED EXPECTED EXPECTED EXPECTED EXPECTED EBIT $6.00$12.00 $18.00 – Int 0.00 0.00 0.00 NI $6.00$12.00 $18.00 EPS $ 1.50$ 3.00 $ 4.50

8. Kevin Campbell, University of Stirling, October 2006 8 EBIT 50% EBIT 50% BELOW ABOVE BELOW ABOVE EXPECTED EXPECTED EXPECTED EXPECTED EXPECTED EXPECTED EBIT $6.00$12.00 $18.00 – Int 5.00 5.00 5.00 NI $1.00$ 7.00 $13.00 EPS $ 0.50$ 3.50 $ 6.50 PROPOSED CAPITAL STRUCTURE 50% Debt (10% Coupon), 2 million Shares (millions omitted)

9. Kevin Campbell, University of Stirling, October 2006 9 EBIT/EPS analysis Current versus Proposed Current (no debt) Proposed (with debt) EPS 8 6 4 2 0 -2 -4 3 6 9 10 12 15 18 EBIT For EBIT up to £10m, equity financing is best For EBIT greater than £10m, debt financing is best

10. Kevin Campbell, University of Stirling, October 2006 10 The impact of financial leverage If EBIT is > 10, the levered capital structure is preferable, ie EPS is higher If EBIT is < 10, the unlevered capital structure is preferable Conclusion: whether or not debt is beneficial is dependent upon the capacity of firms to generate EBIT

11. Kevin Campbell, University of Stirling, October 2006 11 Indifference Level The break-even EBIT occurs where the lines cross At that level of EBIT both capital structures have the same EPS

12. Kevin Campbell, University of Stirling, October 2006 12 Set the two EPS values equal to each other and solve for EBIT: Current (unlevered)Proposed (levered) (EBIT-Int)(1-T) = (EBIT-Int)(1-T) S S Since we assume T=0 (EBIT-Int) = (EBIT-Int) S S Breakeven Point

13. Kevin Campbell, University of Stirling, October 2006 13 Break-even EBIT (millions omitted)

14. Kevin Campbell, University of Stirling, October 2006 14 EPS U 1.5 3.0 4.5 EPS L 0.5 3.5 6.5 Spread U 3.0 Spread L 6.0 … that’s RISK The impact of financial leverage EBIT 50% EBIT 50% BELOW ABOVE BELOW ABOVE EXPECTED EXPECTED EXPECTED EXPECTED EXPECTED EXPECTED

15. Kevin Campbell, University of Stirling, October 2006 15 The impact of financial leverage Leverage increases EPS if EBIT is high enough. At very low levels of EBIT, EPS can be negative – as interest on debt has priority over payments to shareholders. Financial leverage produces a broader spread of EPS values, ie shareholders’ returns are less predictable. This represents added RISK.

16. Kevin Campbell, University of Stirling, October 2006 16 Summary: EBIT/EPS analysis Indicates EBIT values when one capital structure may be preferred over another Analysis of expected EBIT can focus on the likelihood of actual EBIT exceeding the indifference point

17. Kevin Campbell, University of Stirling, October 2006 17 Because interest on debt is deducted from EBIT before the amount of tax paid is calculated, there is a benefit to debt … in the form of lower corporate taxes Consider an example … The tax benefit of debt

18. Kevin Campbell, University of Stirling, October 2006 18 Firm Unlevered Firm Levered No debt$10,000 of 12% Debt $20,000 Equity $10,000 in Equity 40% tax rate The tax benefit of debt Both firms have same business risk and EBIT of $3,000. They differ only with respect to use of debt. U has $20K in Equity & L has $10K in Equity

19. Kevin Campbell, University of Stirling, October 2006 19 EBIT $3,000$3,000 Interest 0 1,200 EBT$3,000$1,800 Taxes (40%) 1,200 720 NI $1,800$1,080 ROE 9.0% 10.8% Firm U Firm L U; 1.8/20K = 9% L; 1.08 / 10K = 10.8% The tax benefit of debt

20. Kevin Campbell, University of Stirling, October 2006 20 Why does financial leverage increase the overall return to investors? Investors include both: Debtholders (banks & bondholders) Shareholders Total return to investors: U: NI = $1,800. L: NI + Interest = $1,080 + $1,200 = $2,280. Taxes paid: U: $1,200 L: $720 Difference = $480 More EBIT goes to investors in Firm L

21. Kevin Campbell, University of Stirling, October 2006 21  Because the Government subsidizes debt, and the tax savings go to the investors.  The tax savings are called the “tax shield” and grows proportionally with the increase of debt. Why does financial leverage increase the overall return to investors?

22. Kevin Campbell, University of Stirling, October 2006 22 Debt versus Equity Basic point. A firm’s cost of debt is always less than its cost of equity. Why? debt has seniority over equity debt has a fixed return the interest paid on debt is tax-deductible. It may appear a firm should use as much debt and as little equity as possible due to the cost difference … but this ignores the potential problems associated with debt. A Basic Capital Structure Theory

23. Kevin Campbell, University of Stirling, October 2006 23 A Basic Capital Structure Theory There is a trade-off between the benefits of using debt and the costs of using debt. The use of debt creates a tax shield benefit from the interest on debt. The costs of using debt, besides the obvious interest cost, are the additional financial distress costs and agency costs arising from the use of debt financing.

24. Kevin Campbell, University of Stirling, October 2006 24 The costs of financial distress associated with debt Bankruptcy costs including legal and accounting fees and a likely decline in the value of the firm’s assets Financial distress may also cause customers, suppliers, and management to take actions harmful to firm value. A Basic Capital Structure Theory

25. Kevin Campbell, University of Stirling, October 2006 25 Agency costs arise from conflicts between shareholders and bondholders When you lend money to a business, you are allowing the shareholders to use that money in the course of running that business. Shareholders interests are different from your interests, because You (as lender) are interested in getting your money back Shareholders are interested in maximizing their wealth A Basic Capital Structure Theory

26. Kevin Campbell, University of Stirling, October 2006 26 Agency costs associated with debt: Restrictive covenants meant to protect creditors can reduce firm efficiency. Monitoring costs may be expended to insure the firm abides by the restrictive covenants. As the level of debt financing increases, the contractual and monitoring costs are expected to increase. A Basic Capital Structure Theory

27. Kevin Campbell, University of Stirling, October 2006 27 Capital structure: practical considerations In addition to the variables described by the trade-off theory of capital structure, a variety of practical considerations also affect a firm’s capital structure decisions:  Industry standards  Creditor and rating agency requirements  Maintaining excess borrowing capacity  Profitability and the need for funds  Managerial risk aversion  Corporate control

28. Kevin Campbell, University of Stirling, October 2006 28  Industry standards It is natural to compare a firm’s capital structure to other firms in the same industry. Business risk is a significant factor impacting a firm’s capital structure and is heavily influenced by a firm’s industry. Evidence indicate firms’ capital structures tend toward an industry average. Practical considerations

29. Kevin Campbell, University of Stirling, October 2006 29  Creditor and Rating Agency Requirements Firms need to abide by restrictive covenants, which may include restrictions on the amount of future debt. Firms typically desire to appear financially strong to potential creditors in order to maintain borrowing capacity and low interest rates. Using less debt in capital structure helps to maintain this appearance. Practical considerations

30. Kevin Campbell, University of Stirling, October 2006 30  Maintaining Excess Borrowing Capacity Successful firms typically maintain excess borrowing capacity. This provides financial flexibility to react to investment opportunities. The maintenance of excess borrowing capacity causes firms to use less debt in their capital structure than otherwise. Practical considerations

31. Kevin Campbell, University of Stirling, October 2006 31  Profitability and the Need for Funds Profits can be paid out as dividends to shareholders or reinvested in the firm. If a firm generates high profits and reinvests a large proportion back into the firm, then it has a continuous source of internal funding. This will reduce the use of debt in the firm’s capital structure. Practical considerations

32. Kevin Campbell, University of Stirling, October 2006 32 Practical considerations  Managerial Risk Aversion Well-diversified shareholders are likely to welcome the use of financial leverage. Management wealth is typically much more dependent upon the success of the company acting as their employer. To the extent management can act on their own desires, the firm is likely to have less debt in its capital structure than is desired by shareholders.

33. Kevin Campbell, University of Stirling, October 2006 33 Practical considerations  Corporate Control Controlling owners may desire to issue debt instead of ordinary shares since debt does not grant ownership rights. Firms with little financial leverage are often considered excellent takeover targets. Issuing more debt may help to avoid a corporate takeover.

34. Kevin Campbell, University of Stirling, October 2006 34 Summary EBIT/EPS analysis may be used to help determine whether it would be better to finance a project with debt or equity. Firms must trade-off the tax advantage to debt financing against the effect of debt on firm risk. Because of the tradeoff between the tax advantage to debt financing and risk, each firm has an optimal capital structure.

35. Kevin Campbell, University of Stirling, October 2006 35 KONIEC DZIĘKUJĘ ZA UWAGĘ

36. Kevin Campbell, University of Stirling, October 2006 36 Homework… EBIT/EPS Analysis A company is considering the following two capital structures: Plan A: sell 1,200,000 shares at £10 per share (£12 million total) Plan B: issue £3.5 million in debt (9% coupon) and sell 850,000 shares at £10 per share (£12 million total) Assume a corporate tax rate of 50% REQUIRED: (a) What is the break-even value of EBIT? (b) At this break-even value, what is the income statement for each capital structure plan and the EPS? (c) Draw a diagram to illustrate the trade-off between EBIT and EPS